pining for inflation to return


Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.


Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

the late 1970s: the last real inflationary period in the US

inflation in the 1970s

The most recent US experience with a real inflationary spiral came in the late 1970s.  In early 1977, prices were rising at a 5% annual rate.  A year later, inflation was running at 7%.  A year after that, the number was 9%, with 14% posted in early 1980.  Then Paul Volcker was appointed as Fed chairman.  He pushed the Fed Funds rate from 11% to 20%, creating a deep recession but breaking the back of the inflationary psychology that was feeding the accelerating rate of price rises.

There’s an academic debate, itself with political dimensions, as to what caused the spiral in the first place.  One side says it was a series of mistakes by the Fed, whose inflation forecasts were systematically too low–that therefore its setting of short-term interest rates(the main tool it used to regulate the economy) was, too.  The other side says it was Washington’s political meddling.

who lived through it?

If you were in your mid-twenties in 1975, when the world was just emerging from a horrible recession (the UK had to call in the IMF to rescue its economy), and the subsequent inflation problem was just being ignited, you’d be in your sixties now.

In other words, virtually all commentators about the perils of inflation today have no practical experience with the phenomenon.  Most of them are clueless.

two parts to runaway inflation

In my view, for what it’s worth, runaway inflation has two characteristics:

1.  money policy that’s too accommodative (read:  interest rates are too low), and that stays that way in the face of rising inflation, and

2.  a resulting mindset change that accepts rising inflation as a fact of life and seeks to benefit from it.

how people deal with rising inflation

I’ve seen this behavior in the US in the late 1970s, and also in high-inflation emerging economies around the world since then:

1.  The price of everything is going to be higher tomorrow than it is today. So you should buy now, rather than wait.  That’s true of everything …houses, cars, clothes, appliances.  If you have to borrow, do it!  In fact, if you can borrow at a fixed rate, inflation will probably soon make the loan look like a gift from the lender and you’ll profit from that, too.

Companies will load up on extra raw materials inventories, expecting to profit from holding them while prices rise.

2.  Workers will look for protection from inflation through contracts where wages are indexed for inflation (wages will rise in lockstep with the general price level). Companies will look for the same in multi-year sales agreements. Many contracts signed in the 1970s had prices indexed to the CPI or other indices that overstate inflation.  Good for the seller, but this also added to the inflation problem.

3.  Economists talk a lot about “money illusion,” the idea that most people can’t figure out how fast prices are rising.  So they’re satisfied with, say, a 5% raise when prices are going up by 8%.  In reality, that’s a 3% wage cut, after inflation.  Of course, once you’re aware of this possibility, you’ll ask for a 10% pay increase–fueling the inflationary fires.

4.  Investors of all stripes will look for assets that will protect them from rising prices.  Typically, these would be physical things, like property, oil and gas or metals.  At the same time, they’ll shun financial assets.  Investors may even short financial assets by borrowing heavily, at fixed rates when possible.

In fact, in the late 1970s many companies made what turned out to be disastrous acquisitions as they tried to work the inflation game, with, say, an industrial parts maker borrowing heavily to buy a coal mine or a chain of hotels.  These turned into almost certain recipes for Chapter 11 after inflation was tamed.

At one time in Brazil, investors bought used cars and stacked them up in their back yards as inflation hedges.  Sounded good at the time, but…

5.  Stock market investors will look for hard-asset companies or firms that can grow their profits at a faster rate than nominal GDP.  This excludes most defensive industries, like telecom or gas/electric utilities, where rates of return on investment are regulated, or like staples, where large price increases cause consumers to look for cheaper substitutes.

an alternate reality

Sounds like an alternate reality?  I think so.

But that’s the point.  It shows how far away from an inflationary environment we are today.

today’s potential inflation threat

Yesterday I wrote about inflation in general.  My two-post idea has morphed into three, though.  Today I’ll write about the current situation.  Tomorrow, I’ll write about what happened during the last bout of runaway inflation the US experienced, in the late 1970s.

why are the money taps wide open?

It’s partly because we’re wrapping up the fourth year of recovery from the economic lows of 2009 and still have about three million people (2% of the workforce) unemployed.  In those workers lives, today is a repeat of the depression of the 1930s.

As Fed Chairman Bernanke has been saying in testimony to Congress with increasing force, the Fed is not well-equipped to prevent them from becoming part of a European-style permanent underclass.  That’s a job for fiscal policy shaped by the administration and for Congress–stuff like reforming the tax code to stimulate new business formation, or infrastructure spending, or retraining.

But Washington has no interest, leaving the Fed money policy, which is legally obligated through its “dual mandate” to try to maintain full employment, as the only option.  (The Fed’s other mandate, by the way, is to try to create the highest sustainable–meaning non-inflationary–level of GDP growth.)

unemployment is a bigger economic threat than inflation,

in the Fed’s view.  Therefore it feels justified in maintaining its massive money stimulus.

can the situation change?

Inflation in a developed economy starts up when there are more job openings than there are people to fill them.  Companies then begin to headhunt workers away from rivals with large wage increases.  Fast-rising wage levels–together with newly-flush workers’ relative indifference to paying more for things–are what creates overall inflation to spring up.

monitoring the unemployment rate

One way of keeping an eye out for incipient inflationary impulses is to keep track of changes in working hours and wages.  The Bureau of Labor Statistics does this.  The Fed also uses the unemployment rate as its key leading indicator of wages.  The rationale is that it’s hard for a worker to ask for a big raise while there’s a long line of qualified unemployed eager to do the work for the current wage–or less.

one big assumption

Over the past few years there’s been a continuing debate among economists as to how much of the current unemployment is cyclical and how much is structural.

“Cyclical” means that the workers have skills employers want but business in general isn’t strong enough to justify adding staff.  “Structural” means that a potential worker is unemployed because he doesn’t have the skills employers want.  Maybe he can’t use a computer, for example.

The Bureau of Labor Statistics tries to help measure the difference between cyclical and structural through its JOLTS (Job Openings and Labor Turnover Survey) reports.  These show the number of job openings in the US that are currently unfilled.  A new JOLT report comes out at 10am Eastern time today.  The previous one, from May 24th, shows 3.5 million unfilled jobs in the US.  That’s about 10% below the pre-Great Recession highs.  It’s also 75% above the mid-2009 lows of 2.0 million.

to my mind, the JOLTS reports suggest at least part of the unemployment problem is structural–something loose money can’t do anything about.  But no one knows exactly how much this might be.

What if all the open jobs are from tech firms that want to hire college graduates with IT backgrounds, while the three million “extra” unemployed are all high school grads who used to work in construction and have limited computer literacy.  If that were true, we’re already at full employment.  Continuing Fed easing would already be in the process of igniting an inflationary upward wage spiral.

I’m not aware of anyone who is saying this is the case.  But how close are we?  No one really knows.

That’s the risk the Fed is taking–not because it wants to, but because it sees Washington as giving it no other choice.  It’s the reason the Fed is talking about taking its foot off the monetary gas pedal when the unemployment rate is at 6.5%, even though full employment more likely means 5.0%-5.5%.

It’s also the reason, I think, that the financial markets have decided all by themselves in recent weeks–as they typically have in the past–to start to do the Fed’s tightening work for it.

More tomorrow.

is chronic inflation on the way?

I’m going to write about this topic in two posts.  Today will cover background; tomorrow will ask/answer where we stand now.  In a way, these posts are a follow-on to writing about the employment situation in the US.


What is it?

Inflation is a general rise in the level of prices–in other words, in the cost of stuff–that continues over a period of time.

…in a service economy

In a service economy like the US, the largest element in the cost of most things–from financial advice to medical care to computer hardware/software to restaurant meals, and on and on–is the wages paid to the people providing the public with services.  Goods, too.  Because of this, inflation in the US is all about continual rises in wages.

Increases in industrial raw material prices can end up creating inflation here, but only under a number of conditions:

–the price increases for materials can’t be just one-off.  They have to keep on coming.

–manufacturers/ distributors have to pass these cost increases on to consumers by raising their prices, not just absorb them themselves, and

–consumers have to pass the extra costs on to their employers by demanding–and receiving–steady wage hikes.

don’t get inflation started!

Like a lot of things in economics, inflation is partly a state of mind.  A Fed study done when I was just starting out in the stock market demonstrated that at that time consumers’ expectations about future inflation corresponded almost exactly to what actual inflation had been over the prior five years.  It’s not all that surprising that people should extrapolate from recent past experience (what else would you do?), but a problem nonetheless.  If everyone gets it into his head that prices are rising at, say, a 5% annual rate and demands a wage increase that keeps him whole.  So inflation can get institutionalised, as it did in the late 1970s, and become very hard to eradicate.

Multi-year labor contracts may stipulate that wages are automatically increased for inflation–and the define inflation through an index like the Consumer Price Index, which systematically overstates the effect of price rises on the cost of living.  Not a huge issue for today’s US, though.

In addition, inflation tends to feed on itself and starts to accelerate.  In the late 1970s, when an extra-loose money policy sparked inflation, which went from 3% in 1972 to well over 10%–with widespread conviction that inflation would continue to rise–before Paul Volcker stepped in in the early 1980s.

money spigots now wide open again around the world

It’s certainly true in the US and in Japan, and increasingly so in the EU.

The idea is to make the cost of money very low so entrepreneurs will invest and, at the same time, to make the returns low enough on “safe” investments that savers will feel compelled to provide capital.  Why do this?   …to counter the huge economic contraction set off by the near-collapse of the world banking system five years ago.

The risk to this strategy is that, at some point, more productive capacity will be added than there are workers to man it.  If so, labor-short companies will start to poach workers from other firms by offering very large salary increases.  Voilà!  Inflation–always about wages in the developed world–is kindled.

More tomorrow.

US bond market environment, October 2012 (II)

Here’s the second installment of the Bond Market Environment letter to clients by Denis Jamison of Strategy Asset Managers.  The first appeared yesterday.

debt without cost

Federal government borrowing has spiraled since 2008.  Total public debt outstanding–an amount that includes the notional amount owed by the Federal government to the various government trust funds–was $15.2 trillion at the end of 2011 compared with $9.2 trillion four years earlier.  Now, that debt is probably a trillion higher and exceeds nominal Gross Domestic Product.

You would think that much borrowing would put a huge strain on the federal government’s budget.

Well, it hasn’t.

In fact, for the year ended December 31, 2011, the interest payments on the federal debt were just 5% higher than in 2007, despite a 65% increase in the debt outstanding.  Moreover, the interest on the federal debt last year was just 1.5% of GDP.  That’s less than the 3%-plus drain on the country’s earnings during the second half of the Eighties and through the Nineties.

two reasons for this happy situation:

–first, the growth miracle during the Clinton Presidency provided a huge expansion in GDP while temporarily reducing the actual level of federal government debt.  And,

–second, the Federal Reserve’s zero interest rate policies begun in 2008 that reduced the interest cost of that debt from about 4.5% to less than 3%.

The trend in the cost of the federal government’s debt is glacial.  It takes a while for old bonds to mature and be replaced by new ones.  So the federal government’s debt costs will remain manageable for the next few years.  Investors should be very aware that the higher level of  federal debt to GDP plus the extraordinary low level of current interest payments could provide a severe headwind to economic growth down the road.


Bond investors have every reason to be confused.  They have enjoyed thirty years of high rates of return caused by steadily declining interest rates.  For various reasons, we experienced a secular decline in inflation since 1985.  Meanwhile, monetary policy amplified the impact of that decline on bond prices by steadily reducing the real rate of return (the nominal yield less the inflation rate).  We may have gone as far as we can down this road.  Real yields of most US Treasury securities are negative.  That’s happened before–in the Seventies.  Then it was caused by high inflation against a backdrop of loose monetary policy.  The inflation cure involved tight money, sharply higher interest rates and back-to-back recessions in the first half of the Eighties.

While Fed Chairman Bernanke draws parallels between the economic problems of the Thirties with those of today, he might want to consider the legacy of the Burns and Miller policies of the Seventies.  After the 1.5% inflation rates of the Sixties, these Fed chairmen didn’t think future inflation would be a problem, either.  And low interest rates seemed a good idea in exchange for economic growth.

It is likely bond investors will suffer a bear market someday–we just don’t know when.  For the moment, the music is still playing, so you have to keep dancing.

The only way to earn a real return today is to accept greater risk–maturity (or call) risk, credit risk, currency risk, liquidity risk and a lot of other risks that you won’t know are risks until something bad happens.  While I can’t pick the next winners (or losers), I can see a sector by sector return pattern created by the various waves of Federal Reserve policy.

By pushing short-term interest rates to zero, the Fed caused a huge rally in the US Treasury securities.  The gains now are limited because the real yield from these securities has reached zero.  Next, mortgages rallied as they were seen as a low risk alternative to government debt.  Now they, too, are exhausted because, at current price levels, prepayment losses are wiping out most of their coupon income.  That leaves maturity risk and credit risk still on the table for most investors.

maturity risk

The yield spreads between ten and thirty-year bonds are still attractive.  In the US Treasury market, that spread is about 125 basis points.  But the price risk for any change in interest rates is very high.  For example, investors in the current US Treasury thirty-year bonds would lose 15% if rates increase from the  current 3% to 3.5% ove the next six months.

credit risk

Assuming maturity risk isn’t to your liking, maybe the answer is corporate bonds.  Of course, there’s a lot of supply here because companies are busy selling new bonds to pay off old ones.  Maybe all this supply is keeping yields relatively high.  The spread between AAA-rated corporate bonds to ten-year US Treasuries is about 160 basis points.  If you can stomach BBB-rated securities, you’ll earn a 300 basis point advantage over governments.

Investors face difficult choices.  Old strategies aren’t working well in the current investment environment.  Unfortunately, when you step out on a new path, you never know where it will lead.